Throughout 2018 (as is the norm outside of an immediate selling climax), HYG (the US high yield bond ETF) has traded at a premium to its NAV (underlying cash bond values). Then October struck, global liquidity spigots began to dry up more rapidly and high yield bonds were dumped. This pushed HYG into a discount to its underlying as liquidation needs (hedging) in the ETF dominated selling the illiquid underlying positions...

And in Emerging Market Debt, it is a disaster where the relatively liquid ETF is trading at 15% discount to the hugely illiquid underlying EM debt instruments...

As bouts of late-cycle volatility prompt fears of an impending race for the exits, Aberdeen Standard Investments - with $736 billion assets under management - has been switching to products with greater liquidity relative to cash bonds, like credit default swaps. However, most notably, Aberdeen's fixed income manager Luke Hickman is bucking a trend that’s taken hold among many of his peers: he's shunning exchange-traded bond funds, fearing a "blowout" in the passive space within the next two years.

“If you’ve been in the market long enough to remember past blowouts, you know that liquidity is key,” Hickmore said...

“High-yield credit and emerging-market ETFs won’t be well placed to handle a liquidity crunch.”

And, as that fear of a liquidity crunch leaks from cash markets to the ETF, it is the CDS markets that have become a more popular hedging tool for professionals in recent weeks... (while we note the apples to oranges comparisons below, the shifts are notable)

And in Emerging Markets, while EM CDS markets have begun to push higher in risk, the ETF dominated the early hedging but has become extremely expensive (and as we noted above, at a major discount)...

Hickmore reckons many funds in the space have become too inflated, piling into bond ETFs, and they may now struggle to cope with a rush of redemptions.

As Bloomberg notes,record high trading volumes on U.S. swap indexes underscore how managers have become obsessed with finding instruments that will let them stay nimble in a downturn.

“Investors are finding it easier to transfer risk using synthetic index products,” said Anindya Basu, a strategist at Citigroup Inc. in New York.

“Getting in and out is cheaper than buying and selling cash bonds. So when markets sell off they can adjust their exposure to credit beta more easily than transacting in cash bonds.”

Angst over vanishing liquidity was the chief concern among credit buyers in Europe, according to Bank of America’s client survey in August.

“In the later part of the cycle, we’re getting more and more into short-play stories and it’s important to have the liquidity to exit quickly,” Hickmore said.

And finally, while the chart above looks like credit is starting to move, it is still tinkering around near cycle tights - entirely ignoring the fact that leverage has been soaring while central banks have been buying bonds to rescue the world...

We give the last word to the man who manages $736 billion...

“I’d expect a blowout in some of those closer to 2020,” said Hickmore.